Abandonment Issues

 | Oct 13, 2011 | 11:30 AM EDT
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After yesterday's article, I was soundly chastised by readers for my approach to the junk bond markets. I am not a bond trader by any stretch of the definition. Furthermore, I am of the opinion that most non-institutional investors should eschew trading high-yield bonds off spreads or ratios to Treasury or high-rated corporates and instead focus on absolute levels. Income investors have generally been better served by high-yield stocks than bonds over the past three years, and, in my opinion, owning high-quality blue-chip stocks carries less risk than holding junk bonds.

I do, in fact, buy junk bonds, however, based on the opinion that everything is going to go bankrupt and price off recovery rates. It is not an original idea; I stole it from the writings of Martin Whitman of Third Avenue. I want to buy instruments such as junk bonds when everyone else has sold and buyers are scarce.

It is the approach I try to take in all my investing activities. I am primarily a deep-value, asset-based stock picker. I look for stocks that not one else wants and that appear underpriced relative to the value of the assets. The first question I always ask when approaching a stock or any other asset class is what can go wrong and what it is worth in the worst possible scenario. I can remove day-to-day, or even year-to-year, price fluctuation and take out a lot of the risk of permanent capital impairment with this approach. The upside in these situations tends to take care of itself.

This is not a new idea either. Jim Rogers's calls it looking for dollar bills in the corner. Seth Klarman refers to it as looking for the forced selling. Baron Rothschild famously called this approach waiting until you saw the blood in the streets. Sir John Templeton referred to this approach as buying at the point of maximum pessimism. It is not based on being right every day or every quarter but on making the right call every five years or so on a stock, sector or assert class. I am a decent balance sheet analyst and terrible short-term trader. Any success I have had over the years has come from being patient enough to wait for things to be unloved and unwanted before starting to buy.  Of course, similar to Joe Kennedy, I have also always sold too soon.

Every once in a while, as part of this approach I will pull out some charts on various assets, commodities and stocks to see if anything is reaching that point of maximum pessimism. I did this several months ago and mentioned then that the only asset that looked close to really cheap was the U.S. dollar. Since that time, it has bounced about 10%. Today, I do not see any charts that seem to be spilling blood into the streets. Even markets that have been weak this year (e.g., copper) are still pretty rich on a long-term view. Grains have been weak in recent weeks, but corn is still twice the 2009 lows and soybeans are about 50% above the lows. They may appear cheap on a near-term basis, and certainly those who specialize in various commodities and asset classes might have a more informed short- to intermediate-term view than I, but nothing looks abandoned enough to spark my interest right now.

Real estate and smaller banks remain the most unloved asset classes in the world right now. I have expanded that list to include select European and Japanese banks this year, and I have bought stocks such as Royal Bank of Scotland (RBS) and Mitsubishi UFJ (MTU). I do not expect a smooth ride, as the short term will likely prove to be difficult for these stocks. Indeed, most of my shopping center plays, such as Kite Realty (KRG), have continued to move lower. I have learned to wait until I think it cannot possibly get worse and then buy on a scale as things get worse.

There are much more sophisticated approaches to investing and trading. Many of them work very well. Many friends of mine are relative value and statistical traders who are very active on a daily or weekly basis in the markets. It is just not the approach that I favor, and fortunately my absolutely cheap and patient approach has worked out fairly well over the years.

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